Day traders in commodity futures, stock, and currencies primarily focus on short term price fluctuations. However, it is always wise to have an appreciation for longer term trends and the factors that are driving those trends. An approach that helps spot long-term, recurring price patterns is called Elliott Wave Theory. This approach identifies so-called impulse wave patterns as well as waves that oppose or correct the long-term trend. This is sometimes called a fractal approach to investing.
How Does the Elliott Wave Theory Work?
Elliot wave patterns are meant to set in order the various probabilities of future prices. This approach is not meant to be used alone but in conjunction with other technical indicators. What Elliot waves show you is the repeating up and down movements of the market you are trading which are, in turn, driven by the composite sentiment of those trading and investing. The main “waves” or long term fluctuations are called impulse waves and the superimposed shorter term waves are called corrective waves. One might think of an impulse wave being the war in Ukraine in which a major exporter of corn, wheat, and sunflower oil is unable to plant, harvest or ship their products while a corrective wave is other producers planting more acreage to make up for the shortfall.
Elliott Wave Theory Indicator
The indicators in this system are the waves. To have predictive value they need to conform to the rules devised by the originator of this system, Mr. Elliott back in the 1030’s. The major wave, the impulse wave, should include five sub-waves which all contribute to movement in the same direction. If the sum total of price movement does not conform to the specified pattern it is not and Elliott wave and does not have the predictive potential embodied in a proper Elliot wave.
Elliott Wave Theory Rules
The Elliot wave theory rules for an impulse wave are that there need to be five corrective waves within the main impulse wave. Three of the sub-waves are motive waves and two are corrective waves referred to as a 5-3-5-3-5 structure. The rules that apply are that wave 2 can’t retrace more than 100% of wave 1. Wave 3 can never be the shortest wave of 1, 3, and 5. And, wave 4 may not ever go beyond the limits of wave 3 and any point. If a wave does not conform to Elliot wave theory rules it does not have the predictive value of one that does.
What Is a Flat in Elliott Wave Theory?
A side-ways pattern in this system is called a flat. It is three waves that oscillate along a straight line. Waves are labeled A, B, and C and are a counter-trend corrective pattern. This pattern typically retraces the prior trend and functions as a warning sign. However, it can also be an indicator of an indeterminate market and nothing else. This is a good example of why Elliot wave indicators are never to be use alone but as an adjunct to other technical indicators.
Elliott Wave Theory Downtrend
It can take years of study to master the intricacies of Elliott wave theory. But, in order to help spot potential breakouts such as new uptrends and downtrends basic principles of this system can be applied. The system is very precise in noting if one wave exceeds the previous or following wave. In order to benefit from the prediction of an Elliot wave theory downtrend a trader will be best served by applying technical indicators like moving averages to make any moment by moment trading decisions.
Elliott Wave Theory Fibonacci Numbers
Practical use of Elliot waves requires being able to spot when one wave ends and the other begins. One of the useful tools for this task is to use Fibonacci numbers. These numbers are derived from sequences in which a number in the sequence is equal to the sum of the two previous numbers. What matters are not the specific numbers but the ratios that emerge again and again. While this is another somewhat complicated approach it can help in the analysis of Elliott waves.
Elliott Wave Theory Criticism
Criticism of Elliott wave theory ranges from it being a bunch of hocus pocus to the practical criticism that it can be really complicated, requires use with other technical indicators to be useful, and only provides long term insights. For a day trader trading commodity futures, a better approach is to learn a proven system such as from DayTradeSafe so that one has a discipline-based approach for entry into, management of, and exit from one ‘s trades.